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Reforms for Chinese Banking

In an eerie echo of the financial crisis of 2008, the rates at which Chinese banks lend to each other shot up last week, sending a wave of panic through global stock and bond markets. The sudden jump highlighted systemic problems in the country’s financial system that will test the ability of Beijing’s new leaders to reform the world’s second-largest economy.

On Tuesday, the Chinese central bank tried to soothe markets by saying that it had already injected funds into some financial institutions, which caused overnight interbank rates to fall to 5.7 percent, down from a record high of 13.4 percent on Thursday. But policy makers need to push through more far-reaching reforms to prevent a panic.

Many of the weaknesses of the banking system can be traced back to the government. Policy makers artificially depress the interest rates that banks pay their depositors while directing them to dole out cheap loans to favored government agencies and companies that may never be able to repay the loans and survive only by borrowing more money. While that has powered growth, it has also encouraged consumers to invest in risky real estate and financial schemes to find higher returns. And they have propped up inefficient state-owned firms while forcing private businesses to seek expensive loans from a shadow banking system with few regulations.

Analysts say the jump in lending rates was caused by a government attempt to discourage banks from lending to the shadow banking system. It did that by limiting how much money the central bank was lending to banks.

What the government should do now is move to stop controlling the interest rates on savings accounts, which are lower than inflation. Removing controls over those rates would reduce the demand for risky investment plans and reward ordinary savers. Another important reform, but one that would be much harder to implement, would be to reduce the influence that government and Communist Party officials have on loan decisions, freeing bankers to lend to deserving businesses, rather than inefficient state-owned firms.

It will take years to carry out these reforms fully and the government will face significant opposition from provincial leaders, bankers and others who benefit from the current system. But policy makers cannot afford to be complacent in dealing with banking excesses.